Reuters | US leveraged loans hit turbulence, but will avert a crisis repeat

Dec 17 The leveraged finance market is not set to repeat the credit crisis of 2007-2008 despite severe dislocation in the credit markets at year end after a slump in crude oil prices and a rout in the high-yield bond market, industry leaders said.

Although market conditions could be painful for banks trying to work through a multibillion dollar backlog of leveraged loans in early 2016 after a US$5.5bn buyout financing for software maker Veritas was pulled in November, the banking system is better capitalized and capable of dealing with problems.

“This is not the start of an ’07-’08 nightmare where banks are stuck with a bunch of bad loans, but there could still be some painful deals in the market where they’ll have to take a hard mark to market,” said Highland Capital chief investment officer Mark Okada, noting that banks have plenty of capital and the banking system is healthy.

Highland is an investment adviser that specializes in credit with approximately US$21bn of assets under management.

Federal Reserve chair Janet Yellen echoed this sentiment on Wednesday after announcing that the central bank was raising interest rates by 25bp for the first time in almost a decade.

“I think we have a far more resilient system now than prior to the financial crisis,” she said.

Investors are focused on credit selection amid a flight to quality ahead of rising default rates and are showing a clear preference for larger, more liquid deals for higher-rated companies.

Leveraged loans traded down in the secondary market in 2015 for several reasons, including earnings, as investors tried to avoid booking loans that drop in value and would have to be sold at a loss if funds have to meet redemptions.

Okada said that corporate credit investors are factoring in illiquidity that is not yet reflected in the equity market, which explains why debt prices remain on the ropes after a steep drop in late August.

The SMi100 index of the largest loans in the market was quoted at 96.55 on Dec 15, down from 98.79 at the end of August, according to Thomson Reuters LPC data, which is making it difficult to sell new leveraged loans at face value.

The S&P 500, on the other hand, closed on Wednesday at 2,073 after dropping to 1,972 at the end of August. The stock index was trading above 2,100 earlier in August and fell as low as 1,881 in September.

“I think that credit has been properly pricing in both liquidity and fundamental risk and equities have been late to the party, and I think that this is going to be a theme for 2016,” Okada said.

Liquidity is key for credit investors as banks stop making markets in deals due to capital and regulatory constraints and was one of the reasons that Third Avenue Management – one of three high-yield funds to get into trouble recently – put redemptions on hold.

SECONDARY BARGAINS

The US leveraged loan market is now presenting some interesting investing opportunities, particularly in the secondary market and investors will benefit from a stock-picking mentality, Okada said, as they seek higher returns to compensate for perceived illiquidity.

“This liquidity dynamic continues to be something that gets priced into our market. We see it as an opportunity to get paid more because of the perceived or potential illiquidity,” Okada said.

“If you don’t have a fundamental liquidity problem at the issuer level, this dislocation that we’re seeing can actually create great opportunities for investors,” he added.

Other investors are also seeing current market dynamics as a potential buying opportunity, but are wary of catching a falling knife and are waiting for the new year before buying.

“In some ways we like a little volatility. We may pass on a deal, and if it’s now struggling, we may look at it again and see if it makes more sense where it’s being talked at now,” one investor said.

Average spreads on B2/B3 names have jumped to 877bp from 710bp at the start of the year while average yields on Ba1/Ba2 names have increased to 486bp from 442bp, LPC data shows.

This repricing could create difficulties for banks that are trying to sell deals that were postponed for syndication in 2016, including the US$5.5bn Veritas buyout financing, unless companies can show improvement in the interim, several investors said.

Finding a clearing price for those deals may require further painful concessions from banks which will be less able to underwrite new deals until those deals are sold.

“Banks are very good and aggressive at finding a level that will clear,” a second investor said. “We saw that with (department store) Belk. They sat on that deal from August and waited until October to launch it. The banks found a price at 89, and probably took a 10 point hit, but they moved it out.”

With deals still waiting to be sold, new heavily leveraged loans backing private equity buyouts are unlikely to find much appetite in early 2016, which could result in a quieter market.

“Given the illiquidity and volatility, we’d anticipate that LBO volumes in particular would probably be lower than in an otherwise functioning market,” said John Sherman, a managing director at DDJ Capital Management.

The market should, however, remain open even if it continues to separate along credit lines as the ‘haves’ are placed and the ‘have nots’ continue to struggle.

“People are willing to extend credit, even if it’s at slightly higher yields or wider spreads, to good companies.” Sherman said. (Editing By Tessa Walsh and Jon Methven)